Corporate tax avoidance not a sign of risky management

Profitable companies that pay little in income taxes aren’t necessarily indulging in risky management practices with their tax strategies, according to a new academic study.

 

The study, by professors David A. Guenther and Steven R. Matsunaga of the University of Oregon and Brian M. Williams of Indiana University, found tax avoidance activities that lower a company’s tax rate are not associated with a greater degree of risk. The study appears in the January/February issue of The Accounting Review, published by the American Accounting Association.

The researchers performed three riskiness tests: whether low effective tax rates that a company achieves prove to be merely temporary and are less persistent then higher effective tax rates; whether low effective tax rates are more predictive than higher rates of future tax volatility; and whether low tax rates are associated with greater uncertainty about a company’s overall future cash flow, as reflected in greater future stock-price volatility.

In all three tests, low effective tax rates proved not to be associated with corporate risk. The study comes at a time when Congress is considering wide-ranging tax reforms that promise to lower corporate taxes from the top rate of 35 percent.

“The current statutory rate may not be to companies’ liking, but we don’t find that it’s driving managers into risky behavior,” Guenther said in a statement. “Our findings suggest a firm’s low taxes to be more reflective of skilled management than risky management.”

The researchers found that not only are companies with low effective tax rates no more likely than other companies to pay higher rates in succeeding years, they are significantly less likely to do so. They found no evidence linking low effective tax rates with future stock price volatility. Instead, some of their results suggested high rates predict future stock price volatility. Even companies that operate in tax havens had no tendency toward higher stock price volatility.

What does appear to be a sign of future financial troubles is not a low tax rate, but ups and downs in effective tax rates. Tax-rate volatility appeared to be predictive of future stock-price volatility. A potential explanation for that phenomenon, the researchers wrote, “is that past volatility leads to greater uncertainty regarding the firm’s future tax rate and overall uncertainty regarding the firm’s future cash flows.”

The findings come from an analysis of the finances and taxes of a large sample of companies over a 25-year period. The researchers calculated the effective tax rates for both taxes that companies acknowledged on their financial statements and the tax payments they actually made over three- and five-year periods.

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